Your Money.

Fund Distributions Are A Taxing Problem

Although Managers Don't Have Control Of All The Factors, They Could Still Do A Better Job For Their Investors

September 08, 1999|By Jonathan Clements, The Wall Street Journal.

Mutual funds are the taxman's best friends. Stock-fund managers make sure of that.

The fact is, funds could easily trim the amount of taxes paid by shareholders. Yet every year, the fund industry blithely sticks investors with huge tax bills. That astonishing indifference has prompted folks to dump their funds and buy individual stocks.

"If the fund is doing well, you don't resent the taxes," says Frances Campra, a 59-year-old retiree in San Francisco. "But there are times when funds don't do well, but you still owe taxes. It's like adding insult to injury."

Campra became so bothered by the tax bills generated by her funds that over the past five years she shifted the bulk of her stock portfolio into individual stocks such as BankAmerica, Cisco Systems and General Electric.

How tax inefficient are stock funds? According to Chicago researchers Morningstar Inc., investors in diversified U.S. stock funds surrendered an average 15 percent of their annual gain to taxes over the five years ended July 31. This figure reflects the taxes paid on fund distributions, but excludes the taxes owed upon selling a fund.

By contrast, you would have lost just 4 percent to taxes if you had owned the Vanguard 500 Index Fund, which doesn't actively trade stocks, but instead simply mimics the performance of the Standard & Poor's 500-stock index. And if you had just bought and held an individual stock that doesn't pay a dividend, you wouldn't have lost anything to taxes.

Admittedly, fund managers aren't entirely to blame. A fund's tax efficiency also is affected by shareholder purchases and sales. Every year, a fund has to pass along to investors virtually all dividends and realized capital gains, in the form of income and capital-gains distributions.

If a lot of shareholders buy a fund during the year, it dilutes the size of a fund's year-end distribution, which makes the fund seem more tax efficient. On the other hand, if investors bail out, the fund may have to sell stocks to pay off these departing shareholders, thus realizing capital gains and generating big taxable distributions for those investors that remain.

Still, even with all these shareholder purchases and sales, stock funds could easily trim their capital-gains distributions. Managers, for instance, might let their winners run for a little longer.

What if they have a profitable position that they really want to unload? They could take a loss on another stock, to offset the gain. If they think the loser has good long-term prospects, they can buy back the stock after 30 days, and the loss will still count for tax purposes.

This isn't complicated stuff. Yet many managers don't bother with such rudimentary tax management, thereby hurting many of their shareholders.

According to the Investment Company Institute, the Washington-based trade group for the mutual-fund industry, only some 40 percent of stock-fund assets are held in tax-sheltered accounts such as 401(k) plans and individual retirement accounts. A small portion of the remaining 60 percent are tax-exempt institutional investors and trusts. But the bulk of these other investors, accounting for maybe half of all stock-fund assets, are taxable.

That indifference is reflected in the astonishing speed with which managers buy and sell stocks. Strong Discovery Fund, for instance, has had average annual portfolio turnover of 450 percent over the past five years, implying a typical holding period of less than three months. Not surprisingly, its five-year post-tax return is 39 percent lower than its pre-tax annual gain.

The rapid trading of stock-fund managers, and resulting tax inefficiency, makes it almost impossible for taxable shareholders to beat the market. Stein figures that, with the 100 percent turnover rate that is typical for a U.S. stock fund, a manager has to beat the market by between 2 1/2 and 3 1/2 percentage points every year to match the post-tax returns of a comparable index fund.

Unfortunately, fund managers show no signs of slowing their trading, so tax-conscious investors need to take matters into their own hands. If you really want to own high-trading stock funds, plunk them in your retirement account.

Meanwhile, for your taxable account, consider index funds, which tend to be tax efficient. Also look into tax-managed funds, such as those offered by Fidelity Investments, T. Rowe Price Associates and Vanguard Group.

A taxable account is also a good place to buy individual stocks, assuming you can resist the urge to trade. Todd Sheets, a 44-year-old chiropractor in Lake Forest, Calif., does just that. Four years ago, frustrated by poor performance and big tax bills, he sold his funds and spread the money among 11 individual stocks, including America Online, IBM and Microsoft.

Thanks to this portfolio makeover, "I never realize capital gains or pay management fees," Sheets says. "How could I do any worse than my old mutual funds?"